Monday, February 07, 2011

Siegel States Equity Premium 3.1%

Jeremy Siegel is touting stocks, with his latest at last week's TD Ameritrade Institutional conference:

U.S. stocks have had an average annual real (after inflation) return of 6.7% between 1802 and 2010, compared with 3.6% for bonds. While there are good decades and bad for all asset classes, Mr. Siegel thinks that the long-term trends will hold true for equities.

He didn't say it, at least in the newspaper quote, but the implication is that is the expectation, as well (even greater for today, because of current undervaluation). Now, Jeremy does not correct his number for adverse flows, the fact that people, in aggregate, put more money into stocks before bad times than before big increases. He also does not adjust for taxes, or transaction costs. The latter must have been terrible, because before computers, the brokers surely could have given clients prices near their daily lows and no one would now (currently there's a little kerfluffle over this in FX bank pricing). The survivorship bias of always using the US and other markets that were extremely fortunate (unlike Poland, Japan, or Russia), is also ignored. Those are each major adjustments, taking out a couple percent of the return.

Further, looking at the data back to 1802, one must remember our grandparents didn't appreciate survivorship bias. As Bill Schwert of the University of Rochester observed about one portion of the data:

From 1825 through 1845, [Smith and Cole (1935)] created an equal-weighted portfolio of six New York banks and one insurance stock. For both of these portfolios, Smith and Cole omitted most of the stocks for which they had collected price data. They chose stocks in hindsight to repreesnt typical movements in the period. Further, to think these data had only tens or less of stocks for any one time highlights how precarious these estimates are. The sample selection bias caused by only including stocks that survived and were actively quoted for the whole period is obvious.

Basically, in the bad old days, every couple of generations a couple professors would look at an industry that survived, on the one exchange that flourished (Charleston, S.C., New Orleans, and Norfolk, Va. had vibrant exchanges at one time), and then take within that those stocks with complete data over a period.

Obviously, this make the sample cleaner with regard to annual fluctuations, which were the major concern, but the averages of this clearly inflate sample returns. One cannot reject the hypothesis that the rate of return on stocks is no greater than that for bonds.

I agree these affect bonds too, but I still think the effect eliminates the difference once these are taken out. To those who point to the zeroing out of bonds and equities by Japan et al, that merely highlights similar returns, -100%, when you lose a war. Too simply ignore these adjustments , and to look at the survivorship top-line arithmetic returns, is a joke, but that's how real 'science' is done--look for the number you expect, then stop asking questions.

Putting aside problems with data, as an equity holder you are subordinated to debt, and as such, I would say that any rational holder of equity in a levered capital structure would demand a higher rate of return.

Is your response to this simply that people, on average, are "bad" investors, and that this pushes the equity premium to 0?

This would mean that when we look at the accounting statements of mutual funds and pension funds ex flows, we should see a constant deterioration in their equity portfolios. It's one thing to say that retail investors or mutual funds cannot beat an index (has to be true for half the investors by definition) and another to say that they constantly lose money. Negative returns would also mean that the government would not have made money collecting capital gains from equity investments (in fact should be losing because the 3000 that can be applied to income). Setting capital gains taxes to zero on equities should be a no brainer.

Adding in "adverse mkt timing" is silly. The indices are an achievable strategy. That some vary their bet on the indices to their detriment doesn't change that. Anyone guessing at the risk premium on say the S&P 500 is implicitly, saying "this is what you get if you just stay in the S&P 500 and don't do anything heroic or stupid." Eric, you have a separate argument about adverse market timing, but don't sneak it in here in your jihad to say there is no risk premium. You may still be right, but not for this bad reason.

"The survivorship bias of always using the US and other markets that were extremely fortunate (unlike Poland, Japan, or Russia), is also ignored. Those are each major adjustments, taking out a couple percent of the return."

Eric this has actually been discussed and quantified in the literature and turns out to be a small bias. Dimson Marsh and Staunton find that an investor in 1900 holding an equal portfolio in all markets (including the ones you mention) the impact of "dead markets" is not more than 0.1% for long run equity returns.

"Is your response to this simply that people, on average, are "bad" investors, and that this pushes the equity premium to 0?"

I think his response is that the data doesn't support the equity risk premium theory, because most putatively riskier assets under perform the less risky assets, i.e., investors generally aren't getting rewarded for assuming more risk.

Dimson notes they use only 17 of 33 stock exchanges that existed in 1900. He then value weights them, and find the excluded markets about 10% weighting--small, irrelevant. I'm interested in the average return to your average investor. Japan, Chile, Germany, Peru, Portugal and Argentina all have 'gaps' in their time series due to wars and such that are rectified using very different methods, which obviously massively affect the geometric means of these time series. But there's always been a valid argument whether market or equal weighting is more relevant, because equal weighting proxies a lot of smaller firms that are not on exchanges--and for most of the tweentieth century most equity capital was not listed on an exchange.

Excluding Russia, South america, and China, excludes a lot of poor schmucks who naively expected a high return for their risk.

As per adverse selection not mattering even if true, I think the bogey is what the average return to the average investor. That's much more meaningful than the average return to a hypothetical investor who, with obeys an equal dollar investing rule. One applies to real people, the other, imaginary.

There has actually never been an argument about whether equal vs. value weighted is more appropriate - it's value weighted. Your "proxy" argument says "OK, the value-weighted exchanges do well, and have a risk premium, and are achievable, but something else, small firms and the non-listed firms they 'proxy' for, have no risk premium." Between this and your "timing" subtraction you are really pushing logic to make your anti-equity point.

And again there is a hidden good argument. That some markets went away but the world market didn't matters a lot because, whether through lack of alternatives or bias, investors historically did not diversify much (not even by number of names let alone by country). It's better now, and far more "optional" as lots of good alternatives exist, but the bias is still there. So, investors actually had to bear the single country risk, and thus the equity risk premium may have been higher historically as compensation for this risk. That's an argument why the risk premium GOING FORWARD can be lower, not an argument why it didn't exist in the past.